For typically small (departmental) environments consisting of 5 physical PC servers (more or less) running departmental applications, what would be the best server consolidation approach ? Do we use server virtualization ? Do we use SAN or NAS ? Would VMWare or Citrix Xen be best suited for this? What's Microsoft's approach to this ?
Very important: we need to focus on benefits and justifications of why one proposed solution is better than the other in terms of cost, time to implement, ease of implementation, and any other factors you think apply to this question.

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For a small environment, VMware has a package for at most 3 ESX Hosts can be part of a cluster to be the new home of your environment and grow as needed.

I would get this package and utilize 2 physical hosts to provide redudancy and high availability despite any hardware failures. In your situation, that physical server hosting that application would be down. With VMware with HA/DRS, your application would be available on another physical server.

1) 2 Physical Servers (Dell would be the least expensive) or utilize existing as long as they are identical (memory and cpu in particular)
2) Hardware-based iSCSI SAN (Dell offers some packages that you can consider)
or
Software-based iSCSI SAN (something like this: http://www.starwindsoftware.com/free)

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Dont forget about Hyper-V, it is a reliable and cost effective solution for consolidation. I've worked with both VMware and Hyper-V, and the basic functionality is the same. You will have to spend a great deal more on VMware to get their enterprise class licenses for live migration.

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